Working capital concepts and policies - Elements of working ...

Learning Outcomes

After reading this article, you will be able to identify the main elements of working capital, explain the concept of the working capital operating cycle, and describe the importance of managing liquidity for business survival. You will understand how cash, inventory, receivables, and payables interact and be able to analyse basic policies for working capital control and financing.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand the nature and management of working capital. In particular, you should be able to:

• Define the components of working capital (inventory, receivables, payables, cash)
• Explain the operating cycle and its stages
• Discuss the significance of working capital to liquidity and business health
• Identify simple policies for managing and financing working capital
• Recognise the consequences of poor working capital control

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following items is NOT a component of working capital?
   1. Inventory
   2. Non-current assets
   3. Trade payables
   4. Cash
2. What does the working capital cycle measure?
   1. Total ownership of a business
   2. Time to convert inventories into cash
   3. Annual profit growth
   4. Number of employees per department

3. True or false? Increasing the average payment period to suppliers will decrease the length of the working capital cycle.

4. Why is monitoring working capital levels important for a business?

Introduction

Efficient working capital management ensures a business can pay its obligations and continue trading. Working capital covers everyday resources used in operations, such as inventory, receivables, cash, and payables. Mismanagement can lead to cash flow problems or wasted resources. Understanding the elements of working capital and the flow of funds through the operating cycle is critical for financial decision-making and is frequently examined in ACCA assessments.

Key Term: working capital
The difference between current assets (such as inventory, receivables, and cash) and current liabilities (such as payables), representing the funds available for day-to-day operations.

ELEMENTS OF WORKING CAPITAL

Working capital consists of short-term assets and liabilities generated through normal trading activities.

Current Assets

• Inventory: Goods held for sale or use in production, such as raw materials or finished items.
• Receivables: Outstanding invoices for goods or services supplied to customers on credit.
• Cash and cash equivalents: Money in hand or in the bank, plus highly liquid short-term investments.

Current Liabilities

• Payables: Amounts owed to suppliers for goods and services purchased on credit.
• Short-term borrowing: Bank overdrafts or loans due within one year.

Key Term: current asset
An asset likely to be converted into cash within one year or the business’s operating cycle.

Key Term: current liability
An obligation expected to be settled within one year, usually from normal operating activities.

The net amount—current assets minus current liabilities—is a basic indicator of short-term financial health.

THE OPERATING CYCLE

The operating cycle, or working capital cycle, tracks how funds move through the business from spending on materials to collecting cash from customers.

Steps in a Typical Cycle

1. Purchase inventory
2. Hold inventory until needed for production or sale
3. Sell goods or services
4. Wait to receive payment if sold on credit
5. Use incoming cash to repay suppliers and restart the process

Key Term: operating cycle
The period from paying for inventory (or other current assets) to collecting cash from sales.

Length of Cycle

The length of time tied up in this cycle affects cash flow. A typical cycle can be calculated as:

• Inventory holding period
• Plus: Receivables collection period
• Less: Payables payment period

A longer cycle increases the need for working capital finance. A shorter cycle improves liquidity.

Worked Example 1.1

A small business holds raw materials on average for 40 days, produces finished goods in 20 days, sells on credit terms averaging 30 days, and pays suppliers after 25 days. What is its operating cycle?

Answer:
Operating cycle = (40 + 20) + 30 – 25 = 65 days. The business’s cash is tied up for an average of 65 days before being collected from customers.

IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Sound working capital management avoids both cash shortages and excessive idle assets.

• Too little working capital risks missed supplier payments, inability to meet customer orders, and even insolvency.
• Too much working capital means funds are locked up in inventory or debts that could be better used elsewhere.

Management must monitor and control the main elements:

• Inventory: Avoid overstocking or stockouts
• Receivables: Minimise late payments and bad debts
• Payables: Utilise supplier credit without harming relationships
• Cash: Maintain sufficient balances, invest excess funds, or arrange facilities

Key Term: liquidity
The ability of a business to meet its short-term financial commitments as they fall due.

BASIC WORKING CAPITAL POLICIES

Businesses must set policies for each working capital area:

• Inventory: Set reorder points, safety stock levels, and review slow-moving items
• Receivables: Establish clear payment terms, perform credit checks, and follow up overdue debts
• Payables: Negotiate suitable payment periods and settle within agreed terms
• Cash: Prepare cash budgets, establish minimum balances, and monitor actual against forecast

There is always a trade-off between risk and return. For example, granting extended credit to customers may increase sales but worsen liquidity.

Worked Example 1.2

Suppose a business currently pays suppliers after 20 days but negotiates new terms extending this to 35 days. How does this affect the working capital cycle, and what are the risks?

Answer:
Extending payment to suppliers lengthens the payables period, which shortens the operating cycle and improves liquidity. However, suppliers may react negatively, or early payment discounts could be lost.

Exam Warning

Be careful not to confuse profits with cash flow. A company can show a profit but become insolvent if cash is tied up in receivables or inventory and is unable to pay creditors.

Summary

Working capital represents the essential resources a business needs for everyday trading. Managing inventory, receivables, payables, and cash is essential for liquidity. The operating cycle links these elements, measuring how long funds are committed. Adopting basic working capital policies supports financial stability.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify the components of working capital: inventory, receivables, payables, and cash
• Calculate and interpret the operating cycle and its impact on cash needs
• Explain why liquidity and working capital management are critical for business survival
• Outline basic policies for controlling inventory, receivables, payables, and cash

Key Terms and Concepts

• working capital
• current asset
• current liability
• operating cycle
• liquidity